Question

British Columbia Lumber has a raw lumber division and a finished lumber division. The variable costs are as follows:

Raw lumber division: R100 per 100 m² of raw lumber
Finished lumber division: R125 per 100 m² of finished lumber

Assume that there is no m² loss in processing raw lumber into finished lumber. Raw lumber can be sold at R200 per 100 m². Finished lumber can be sold at R275 per 100 m².

Required:

2.1 Should British Columbia Lumber process raw lumber into its finished form? Show your calculations.

2.2 Assume that internal transfers are made at 110% of variable costs. Will each division maximise its division contribution by adopting the action that is in the best interest of British Columbia Lumber as a whole? Explain.

2.3 Assume that the internal transfers are made at market prices. Will each division maximise its division contribution by adopting the action that is in the best interest of British Columbia Lumber as a whole? Explain.

Answer 1

. 1. Sell as raw lumber for $200 per 100 board feet:

  

Revenue	$200
Variable costs	100
Contribution margin	$100 per 100 board feet

  Sell as finished lumber for $275 per 100 board feet:

Revenue	$275
Variable costs: Raw lumber        $100 Finished lumber    125	225
Contribution margin	$ 50 per 100 board feet

British Columbia Lumber will maximize its total contribution margin by selling lumber in its raw form.

An alternative approach is to examine the incremental revenues and incremental costs in the Finished Lumber Division:

Incremental revenues, $275 – $200	$ 75
Incremental costs	125
Incremental loss	$ (50) per 100 board feet

2. Transfer price at 110% of variable costs:

= $100 + ($100 ´ 0.10)

= $110 per 100 board feet

	Sell as Raw Lumber	Sell as Finished Lumber
Raw Lumber Division
Division revenues	$200	$110
Division variable costs	100	100
Division operating income	$100	$ 10
Finished Lumber Division
Division revenues	$ 0	$275
Transferred-in costs		110
Division variable costs		125
Division operating income	$ 0	$ 40

· The Raw Lumber Division will maximize reported division operating income by selling raw lumber, which is the action preferred by the company as a whole.

· The Finished Lumber Division will maximize division working pay by selling completed timber, which is in opposition to the activity favored by the organization in general.

3. Transfer price at market price = $200 per 100 board feet

	Sell as Raw Lumber	Sell as Finished Lumber
Raw Lumber Division
Division revenues	$200	$200
Division variable costs	100	100
Division operating income	$100	$ 100
Finished Lumber Division
Division revenues	$ 0	$275
Transferred-in costs(market price)		200
Division variable costs		125
Division operating income	$ 0	$(50)

Transfer at market price will result in division actions that are also in the best interest of the company as a whole. Because the Raw Lumber Division will be indifferent between selling the lumber in raw or finished form, it would be willing to maximize division operating income by selling raw lumber, which is the action preferred by the company as a whole. The Finished Lumber Division will maximize division operating income by not further processing raw lumber and this is preferred by the company as a whole.